Exchange Traded Funds
Exchange Traded Funds (ETFs) are passively-managed and open-ended funds, which are traded on the securities market of Hong Kong Exchanges and Clearing Limited (HKEx). ETFs are designed to track the performance of their underlying benchmarks (eg an index, a commodity such as gold, etc) and offer investors an efficient way to obtain cost-effective exposure to a wide range of underlying market themes. Similar to other securities, investors can buy or sell ETFs through their brokers anytime during the securities market’s trading hours.
ETFs can be broadly grouped into two types:
Physical ETFs
Many of these ETFs directly buy all the assets needed to replicate the composition and weighting of their benchmark (eg constituents of a stock index). However, some only buy a portion of the assets needed to replicate the benchmark or assets which have a high degree of correlation with the underlying benchmark but are not part of it.
Synthetic ETFs
These ETFs do not buy the assets in their benchmark. Instead, they typically invest in financial derivative instruments to replicate the benchmark’s performance. The ETFs are required to have collateral when investing in derivatives (details of the net and gross counterparty exposure and types and composition of the collateral are published on the ETF’s website).
The key feature of ETF
Transparency
Each ETF has its own website operated by its ETF manager (a list of ETFs’ websites can be found on the HKEx website). ETFs’ websites provide key information such as the underlying benchmarks and the benchmarks’ constituents, the ETF’s Net Asset Value (NAV), the counterparty exposure and details of
collateral from counterparties. The NAV of an ETF is the sum of marked-to-market values of the individual portfolio holdings plus the portion of the assets held in cash and cash equivalents, less all the accrued ETF expenses. The NAVs of ETFs are calculated intra-day during the trading hours and at the end of the trading day. The end-of-day NAV information may also be obtained on the HKExnews website, in addition to the ETF’s website. Real-time or delayed price quotes for ETFs are disseminated by information vendors and are available on the HKEx website.
Low transaction costs
Unlike unlisted funds, ETFs do not charge any subscription fees. The transaction costs for trading ETFs at HKEx are the same as those for trading other securities, which include brokerage commission, transaction levy, trading fee, trading tariff and stamp duty.
Liquidity
ETFs can be traded any time during the trading hours of the securities market. Listed ETFs usually have market makers, which are known as Securities Market Makers, to provide some liquidity. However, market making for the ETFs is available only during the Continuous Trading Session.
Diversification
Most ETFs track a portfolio of assets to provide diversified exposure to selected market themes. However, ETFs may also track a single underlying asset.
Convenience and Market exposure
ETFs are traded through brokers in the same way as other securities and the settlement arrangements are the same. While some ETFs provide Hong Kong investors access to a basket of Hong Kong securities, others provide the investors access to overseas markets or other asset classes.
Risks Associated with ETFs
Counterparty risk
Synthetic ETFs are subject to counterparty risk associated with the derivatives issuers and may suffer losses if the derivatives issuers default or fail to honour their contractual commitments. Further, potential contagion and concentration risks of the derivative issuers should be taken into Account. Although synthetic ETFs have collateral from their counterparties, it may not completely remove the counterparty risk so they are still subject to the collateral providers fulfilling their obligations. There is a further risk when the right against the collateral is exercised because the market value of the collateral could be substantially less than the amount secured, resulting in significant losses to the ETF.
Market risk
ETFs are exposed to the economic, political, currency, legal and other risks of a specific sector or market related to the index that it is tracking. ETF managers do not have the discretion to take defensive positions in declining markets. Investors must be prepared to bear the risk of loss and volatility associated with the underlying benchmarks.
Tracking error risk
Tracking error is the difference between the performance of an ETF and its underlying benchmark. Tracking error can arise due to factors such as the impact of the Total Expense Ratio (TER), changes in the composition of the underlying benchmark and type of ETF (e physical vs synthetic). The TER of an ETF may include management fee and other fees and costs (eg transaction costs, stamp duties, costs for preparing financial reports and other prescribed documentation, legal and auditing fees, insurance costs, fees for custody services, etc) – there is no universal definition.
Risk in trading at discount or premium to NAV
The market price of an ETF may be at a discount or premium to its NAV. This price discrepancy is caused by supply and demand factors and may be more likely to emerge during periods of high market volatility and uncertainty. This phenomenon may also be observed in ETFs tracking specific markets or sectors that are subject to direct investment restrictions. As a result, investors who buy at a premium may suffer losses even if the NAV is higher when they sell and they may not fully recover their investment in the event of termination of the ETF.
Liquidity risk
Although ETFs usually have market makers (known as Securities Marker Makers, or SMMs) to help provide liquidity, there is no assurance that active trading will be maintained at all times. In the event that the SMMs are unable to fulfil their obligations, investors may not be able to buy or sell the ETF or may find the market price of the ETF is at a discount or premium to its NAV.
Stock lending risk
Physical ETFs which engage in stock lending face the risk of the borrower not returning the ETF’s securities as agreed and thus may experience some losses due to their stock lending.
